Market View: Estimating fair value

Market View: Estimating fair value

US equity market prices are up more than 300 per cent from the lows of March 2009.

In hindsight, it is reasonable to assume that at least part of this increase has reflected a correction of extremely low pricing of US equities. Moreover, a rise of this magnitude raises the valid question of whether or not US equities are overpriced.

Estimating the fair value of any asset requires the discounting of the expected future cashflow across the life of the investment. This involves an estimate of the cashflow, the risk and uncertainty of this cashflow and the opportunity cost of the capital.

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Comparing price with this estimate of fair value is at the heart of value investing. This applies equally to aggregate equity markets as it does to individual companies.

To apply this to US equities, we can view the aggregate market as an individual company. The US economy looks relatively strong and US firms are profitable across a number of different aspects. However, asset prices should compensate for the prospective risk of investing as the drivers of equity market fundamentals are pro-cyclical.

While the situation looks rosy, revenue, profits, dividends, buybacks and price-to-earnings ratios all tend to fall during economic downturns.

When assessing fair value it is important to normalise for this cyclicality, and the US equity market appears extremely overpriced when using this approach within historically reliable methods.

From this level of overpricing, US equities have typically delivered low medium-term returns. While the fundamentals appear strong, on a forward-looking basis there is a limited margin of safety in the current price.

This implies that the discount rate being applied to future cashflows is low for US equities, and viewing equities as a long-term investment provides an interesting implication.

When discount rates are low, relatively small changes lead to large price movements – and this means volatility.

The prospect of lower returns and larger price movements implies a greater chance of negative returns or losses and an unattractive reward for risk.

The current situation is a natural result of zero interest rates as the lack of available returns from safe assets leads to a search for other sources of return, driving prices higher and prospective returns lower.

Consequently, other assets become priced to deliver low returns. This means in spite of high prices, US equities may still be priced relatively sensibly given the unattractive nature of the alternatives.

This is a relative argument and while the return may be more attractive than low-risk assets, the potential for loss may well have increased.

Equities have a tendency to punish investors when they can least afford it and those preferring a margin of safety will not be enticed. Morningstar thinks there will be more attractive prices in the future, and holding extra cash until then may be the most sensible strategy.